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Short-Term Institutions, Analyst Recommendations, and Mispricing: The Role of Higher-Order Beliefs

March 28, 2019; Dean Martijn Cremers, Mendoza College of Business. (Photo by Barbara Johnston/University of Notre Dame)

Discussions on the role of higher-order beliefs (investor beliefs about the beliefs of other investors) in financial markets can be traced back to Keynes’ (1936) comparison of the stock market to a beauty contest. Investors “are concerned,” he famously said, “not with what an investment is really worth to a man who buys it for keeps, but with what the market will value it at [. . .] three months or a year hence.” Interest in higher-order beliefs models continues today. An anecdotal example of the role of higher-order beliefs is the downgrade of Citigroup by analyst Meredith Whitney in the financial crisis, which caused a large stock-price drop. In her downgrade, Whitney seemed to only reiterate information in reports by other analysts. Because her downgrade was not based on new information, the reaction likely originated from investors that thought Whitney would catalyze investor beliefs.

Despite an extensive theoretical literature, higher-order belief models have received little attention in the empirical accounting and finance literature. In a recent paper, consistent with the predictions of higher-order beliefs models, we find that stocks that have optimistic (pessimistic) consensus analyst recommendations and are currently held by many short-term institutions exhibit large stock-return reversals. Their large past outperformance (underperformance) is followed by large negative (positive) future abnormal returns. The predictable return reversals originate from overreaction to past recommendation releases and the correction of these overreactions around future releases

In standard asset-pricing models with a representative investor, higher-order beliefs do not matter, and stock prices reflect the discounted expected value of future dividends. This is different from models that feature multiple investors with heterogeneous information. In these models, the average expectation of all investors determines stock prices, and investors’ beliefs about other investors’ beliefs can cause a deviation between the prices and the fundamental values of stocks. In higher-order beliefs models, public information plays an important role in the evolution of stock prices. Investors know that public information affects the average belief about the next period’s stock price, as all investors observe the public information and combine it with their private information. Because short-term investors are interested only in the next period’s stock price, they rationally overweight the public signal compared with private signals. This may lead to a short-term overreaction of the stock price to public information, which is subsequently reversed when investors synchronize their trading in the opposite direction to correct the mispricing. We refer to this mechanism as the “higher-order beliefs hypothesis.”

We test this hypothesis by examining whether short-term investors overweight widely disseminated public information about stocks, leading to stock return predictability. For the public information, we use analyst stock-recommendation releases, which are visible and widely followed public events that affect stock prices. At the same time, there are several indications that analyst recommendations contain limited fundamental information. Our proxy for the presence of short-term investors is fund turnover, which is the average portfolio turnover of a firm’s institutional investors. Our tests use U.S. stocks, but we confirm our main results for international stocks. We demonstrate that short-term institutional ownership and extreme analyst recommendations (“strong buys” and “sells”) are mean-reverting over periods of one to two years but not in related ways, which implies that both variables are strongly predictable.

We then document predictable return reversals for stocks with extreme analyst recommendations and ownership by many short-term institutions: Across the same one- to two-year period both the presence of short-term institutions and recommendations mean-revert. Using portfolio sorts, we show that, for high fund-turnover stocks (top quintile), the value-weighted long-short portfolio that sells (buys) stocks with the most optimistic (pessimistic) recommendations has an annualized five-factor alpha of 8.3 percent (t-stat of 3.41). These future alphas reflect return reversals, as the stocks with the most optimistic (pessimistic) current recommendations had positive (negative) alphas in the past. To show that our results are driven by analyst recommendations, we calculate event-time cumulative abnormal returns (CARs) around recommendation releases. The stocks that have the most optimistic (pessimistic) analysts and are held by many short-term institutions had much higher (lower) CARs around previous recommendation releases. Large parts of these CARs are reversed around future recommendation releases, when recommendations revert to the mean.

The return reversals support an interpretation that analyst recommendations act as coordinating signals for higher-order beliefs traders, leading first to return overreactions and then to return reversals. However, the return patterns may also be consistent with an alternative “information-source hypothesis,” which holds that short-term institutions are more likely to outsource their investment decisions to analysts; that is, to use analyst recommendations more strongly as inputs in their fundamentals-based valuations, relative to long-term institutions. To rule out this alternative we test a series of predictions from models of higher-order beliefs.

This post comes to us from professors Martijn Cremers at the University of Notre Dame, Ankur Pareek at the University of Nevada, Las Vegas, and Zacharias Sautner at the Frankfurt School of Finance & Management. It is based on their recent paper, “Short-Term Institutions, Analyst Recommendations, and Mispricing: The Role of Higher-Order Beliefs,” published in the Journal of Accounting Research and available here.

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